Should OCIOs continue to serve non-discretionary clients?
The Outsourced Chief Investment Officer (OCIO) industry continues to grow at a torrid pace. It is a win-win for both the client and the OCIO. The client gets faster execution and greater fiduciary protection expecting better performance. The investment consultant gets a big fee increase while their workload is actually reduced.
Since most OCIOs began as non-discretionary investment consultants, their initial growth has been through converting existing clients to a discretionary (OCIO) relationship. It is an easy decision for the client if they routinely approve their recommendations. Now the recommendations are implemented faster and the client is no longer at political risk for approving (sometimes) poor recommendations.
But not every non-discretionary client chooses to relinquish control. Perhaps they do not convert for reasons of governance and monitoring. Some may believe the fee increase is not justified because they can quickly react and vote on their investment consultant's recommendations. After all, they are getting the same timeliness and quality of advice as the OCIO clients, right? Maybe not.
Consider this sampling of situations investment consultants often face when serving both types of clients. You can then decide for yourself if they can effectively and ethically perform this dual role.
Rebalancing: Timing & Liquidity
Recall the equity market plunge during Q4 of 2018. It presented an excellent opportunity to rebalance if you were nimble. In fact, I published a rebalancing strategy on December 10, 2018 to sell real estate (to the lower end of your target range) and redeploy to equities. It has been a highly profitable move when you compare the subsequent returns.
If an investment consultant came to the same conclusion in mid-December, 2018, they could immediately execute their OCIO clients' redemption orders. If it was simultaneously recommended to their non-discretionary clients, could they meet and vote in time to submit their redemption orders? Even if they met the redemption deadline, they may have still found themselves at the end of the redemption queue(s).
Depending on the size of the investment consultant, their overall allocation to real estate, the liquidity of the real estate manager(s), and the redemption policies of those real estate manager(s), it is possible the non-discretionary clients got squeezed-out of this opportunity with the funding of their redemptions substantially delayed.
Keep in mind this scenario is not limited to real estate, but also other quarterly-valued strategies such as hedge funds, private equity, private debt and infrastructure.
Rebalancing: Market Impact
This rebalancing dilemma is not limited to illiquid or quarterly-valued strategies. Imagine a large investment consultant rebalancing among active managers in smaller markets such as small cap stocks, bank loans or high yield debt. Again, the OCIO clients will act first and likely create a performance drag due to market impact for those acting second. There is the real potential for the non-discretionary clients suffering the double-whammy on both the selling and the buying when rebalancing.
Hiring Active Investment Managers
Investment consultants expend considerable time and effort hoping to discover the next great active manager; an "emerging manager." They seek to invest client assets before the manager has a superior 3-year track record, is flooded with new assets and possibly closes to new investors. OCIO clients again have the speed advantage.
Can an investment consultant risk fair dealing by waiting for their non-discretionary clients to conduct a manager search followed by interviews and then finally vote to hire? If they do, the emerging manager could develop capacity constraints and close to new investors so none of the investment consultant's clients get invested. Fair dealing can hurt their OCIO clients.
For reasons of speed and capacity, for both emerging and established managers, one can see why OCIO clients usually get the pick of the litter while non-discretionary clients may be left with lower quality managers.
Funding & Exiting Illiquid Alternatives
Many institutional investors have greatly increased their allocations to illiquid alternatives. Some investment consultants have over 25% of their clients' assets in such. Occasionally they must increase, decrease or eliminate these holdings depending on their outlook for the asset classes or particular managers.
Like in previous examples, whether buying or selling, acting first can be a big advantage. Imagine an infrastructure or private equity fund has identified acquisitions and then contacts investment consultants seeking new commitments. Depending on the relationships, timing demands and size of the collective commitment, investment consultants will likely be forced to choose which clients get a piece of the action.
Because of the next point, you will see why the OCIO clients will likely always get preferential treatment when profitable, but limited, opportunities arise.
OCIOs Are Feeling The Heat To Perform
Investment consultants have long resisted performance comparisons. This is understandable given that non-discretionary clients have different objectives, different cash flows, unique constraints and may not approve every recommendation in a timely manner, if at all.
Alpha Capital Management has created a series of universes for different client types from over 30 OCIOs. It is a great resource for investors should they already have an OCIO or are considering the switch. OCIOs are managers and no longer consultants. Like investment managers, their performance can now be compared creating the pressure to perform or lose clients.
The ethical dilemma for investment consultants serving both types of clients is now heightened. The benefits enjoyed by OCIO clients at the expense of their non-discretionary clients cannot be denied. And now there is powerful pressure to improve their performance rankings to attract more OCIO clients.
When Will Government & Industry Take A Position?
Despite being a fiduciary to both types of clients, what is to stop an investment consultant from systematically favoring their OCIO clients? OCIO clients pay more, they do not need to vote to approve recommendations, and their performance is now being ranked which can affect future client growth.
Are government regulators investigating the timing and distribution of manager and asset allocation changes by these "two hat" consultants? Is the U.S. Department of Labor ensuring fair dealing and fiduciary standards for investment plans subject to ERISA? If not, government regulators should now take a deep-dive as non-discretionary clients seem to be getting the short-end of the stick at nearly every turn.
Many investment consultants hold the Chartered Financial Analyst (CFA) certificate and have pledged to uphold specific ethical standards. The CFA Institute's Code of Ethics and Standards of Professional Conduct is just 2 pages and appears to address the matter: see Standard III A & B. Click, read and judge for yourself. (Note: I did contact the CFA Institute and they stated they have not issued any specific guidance for this situation. They also stated they may consider the issue in a later version of their Standards of Practice Handbook (2014).) We shall wait and see.
Remedies If You Are A Non-Discretionary Client. ( Remedy #3 is creative. )
If you are a non-discretionary client of an investment consultant that also provides OCIO services, you are now aware of the problems. Here are solutions you should consider:
If you are happy with your investment consultant and your performance has been good, consider becoming an OCIO client. There has recently been fee compression thus reducing the sticker shock. And don't go halfway; be sure to also hire an independent OCIO monitor that is not a competing investment consultant or conflicted, e.g. sells other services or conducts searches.
If you are not happy with your investment consultant, perform a search for a non-discretionary consultant or OCIO. There are pure OCIO and pure non-discretionary consultants in the marketplace today. Vote with your assets!
If you are happy with your investment consultant, but do not want to convert to OCIO, consider forming a sub-committee that can act 24/7 on your investment consultant's firm-wide recommendations. Secure a contractual commitment for fair dealing from your investment consultant, and if you approve their recommendations within 24 hours, your assets will be treated with the same priority and care as their OCIO clients. You get the same advice and stewardship without the added expense.
If you are unsure about your happiness with your investment consultant, perform due diligence to determine if their investment advice is adding value. Consider my firm OCIOmonitor.com for an objective and independent review. After the review, you can then pick remedies #1, #2 or #3 with total confidence.